Facebook (FB) just released impressive growth in revenue, earnings and cash flow. Its forward P/E is now coming down to near 30 and price over projected operating cash flow is coming down to a reasonable 20. Some say the once-hyped-but-now-hated Internet darling is poised to deliver returns to investors. But wait a second, what things investors should seriously consider before jumping into Internet stocks?

The Internet, since its infancy in the 1990s, has been transforming our everyday lives at a rapid rate. For all the things we can now do on the Internet, our options are greater than ever before. We can instantly search a topic we have questions on. We can shop for necessities and entertainment. We can compare prices when faced with multiple deals. We can manage our money. And we can do so much more.

Internet commerce in the U.S., this year, is estimated to be worth about $220 billion, according to a report delivered by Nasdaq. Today’s more enlightened and patient investors are starting to reappraise the potential of Internet stocks. These bargain hunters are wondering if now is the time to snap up shares of Internet companies, particularly those that have recently gone public and are now experiencing distressed prices.

Key Filter Questions for Cyberspace Investors

Are Internet stocks worth a look for bargain hunters? That depends on the sector. Moreover, it depends on the particular company you are looking at. You could have a great industry performing at a high level with a positive outlook but a bad company that doesn’t know how to get it done in that industry section. Or you could have an untested sector with little to no track record but find a great company that is correctly figuring out how to deliver the best value to customers and be profitable. "It's difficult to value a company in newly formed industries with short track records, especially in industries rapidly evolving and subject to significant change," says Allan Mecham, chief investment officer of private investment fund Arlington Value Management. Mecham, of course, is talking about Internet companies that come and go quickly before we really have a chance to get familiar with them. There remains in itself the question of whether or not investing in Internet companies offers anything more than a fair gamble.

Here are three filters for investors to assess an Internet company’s potential:

· Does the company have a sustainable business model in place? Is it able to consistently generate enough revenue to support its operations?

· Are the company’s services engineered to adapt to quickly changing technology? Are they focused on providing a user-friendly experience?

· Do significant barriers to entry exist in the industry in which the company is operating in? Is a particular sector vulnerable to new companies freely entering the market at will? Are newcomers easily able to take away business from established brand names?

Any company’s long-term future is reliant on its ability to generate sustainable revenues and maintain a steady stream of profits throughout the life of the business. Internet companies like Google and Facebook are free and open to all users so they won’t take in revenue from people who use their online services. So how do they make their money? They utilize external sources like advertising sponsorships and strategic pricing initiatives that include charging fees for specific services on their websites.

As a result of the rapid migration to mobile, there exists increasing erosion in display advertising revenues. And mobile is extremely hard to monetize using traditional display and search advertising, resulting in an increasing gap between user growth and profitability. Only 5 percent of the mobile Internet revenues come from advertising while 73 percent comes from display advertising. And 22 percent of revenues come from paid services. For Google and Facebook, their strategies are effective. But is it steady? Look no further than the nature of the company’s operations.

Facebook has enormous brand equity with over 1 billion users worldwide. But it has proved slow to make money from increasing mobile traffic, as the company has been slow to sell ads on its mobile platform. Google, in contrast, has made a truckload of money being the biggest search engine and online advertising platform. And Google, unlike Facebook, has acquired a stake of the mobile market with the Android phone that provides additional revenue to Google. Facebook, outside of its social-networking website service, has a far less diverse range of revenue-generating products.

The jury has been out on Facebook but analyst Andre Sequin of RBC Capital Markets is one who sees the company as a value pick right now. Sequin believes what Facebook needs is to more smoothly monetize its user base: “If Facebook gets it right, the results will be worth multiples of what the company is earning per user today.”

Some investors naturally expect the most popular companies with the strongest brand name to do well. But they forget that popularity can be quick to shine and quick to fade, almost always keeping prices inflated well beyond its true value. They forget that ongoing innovation and marketing can be costly affairs when it comes to sustaining revenues. And they forget that Internet stocks tend to reinvest all their cash flow back into R&D and marketing, driving expenses up and in effect, profitability down. "If the economics and staying power of a business are questionable, then so is investing in it," says Mecham of Arlington Value. And for Facebook, that remains a question mark.

There are two questions we ask ourselves when assessing the technological feasibility of an Internet company: Are its services engineered to be used on mobile devices like tablets and smart phones? Does the website have a user-friendly design that makes it easy for people to navigate? Regardless of what market the website is targeting, users’ opinions often play a huge role in determining a website’s level of success. It doesn’t matter what type of website you run. It just needs to be user-focused.

Amazon and Orbitz are examples of Internet companies in the business of providing a valuable service to customers. Their operations depend on the navigability of its websites and flexibility of use on mobile devices. When customers want to make a purchase at any given time, they gravitate towards the company most likely to provide a hassle-free service in a short period of time. Amazon is the uncontested leading online retailer and will therefore be most consumers' first choice when purchasing everything from electronics to books to music. The layout is attractive, the website is well-organized and most of all, Amazon is reliable and timely with the delivery of its products to customers.

Orbitz, on the other hand, is losing ground in online travel. Recent competitors like Kayak (KYAK) have upped the ante on website design and ease of navigation. Orbitz is no longer a consumer’s first choice when looking to book travel reservations online. The layout is too outdated and it doesn’t compare deals the way similar websites do. The root cause of poor returns for Internet companies like Orbitz is the lack of user-friendly features on its website and on its mobile apps. And the price of Orbitz has been sinking ever deeper by the quarter, with its most recent recorded price at a minuscule $2.40. At that price in such a cut-throat industry, no value exists because users will flock to other online travel companies.

Leading companies get the best out of audiences by engaging them not only on their website but by creating customized apps that can be used on mobile devices. Most companies now have a mobile app in the online marketplace because of increasing pressure from a society that is going increasingly mobile. The way consumers see it, if you are not on the mobile market, your services will not be respected. Investors, therefore, would be wise to steer clear of any Internet companies that lack a mobile presence, as it could be a sign that the company has, at best, a murky future.

The Internet is a far from a commercial space where you can monopolize a particular corner of its economy. It is easy for anyone to set up a website providing any business that services all Internet users. It is easy for entrepreneurs to figure out new ways of doing things that similar companies have not yet perfected. One programmer and a computer is often all that is needed for the next big online concept. Understanding entry barriers to a business is very important. What many investors miss is that the entry barrier is not about technology, it is about understanding the market.

The important aspects of gauging a company’s business are user reviews and the market’s primary needs and desires. Users, more than anything else, will determine a business’ long-term survival in its industry. When positive feedback is provided on websites and to other users, there will be a noticeable increase in business for that company. But on the other hand, Internet companies are always at the mercy of new entrants, regardless of their popularity. Internet companies are notoriously vulnerable to low entry barriers, regardless of industry, unless someone like eBay or Amazon comes along and miraculously gets it right.

Because eBay effectively invented the perfect medium for buying and selling items at any price, entry barriers have always been high in online auction sales. eBay was among the first wave of Internet companies in the 1990s. It survived the dotcom disaster and became very popular with consumers, becoming the definitive choice when looking for hard-to-get items to buy or obsolete items to sell. Theoretically, anybody could choose to set up a website for buying and selling items. But it’s hard to gather so many buyers and sellers already on eBay, which is why the company continues to remain one of the Internet’s most valuable businesses.

Yelp, in contrast, operates in a sector with minimal barriers to entry and therefore unlimited competition. The company operates a website primarily for Internet users to post reviews about everything from restaurants to stores to home services. But Yelp has often found itself vulnerable to new entrants because setting up a website to provide reviews is not a tall task for most Internet users. Another factor that stands in Yelp’s way is the fact that most places, especially restaurants, with a web presence already have their own section of customer reviews. And many people choose to go directly to the restaurant’s website to look at its reviews rather than go to Yelp. The problem with Yelp is that the website lacks in professional appearance and anyone can post reviews that may turn out to be nothing more than nonsense from an immature person. These reviews, of course, can harm a company’s reputation and put its business in jeopardy. On the website of the restaurant, there is more likely to be a greater level of monitoring over the reviews posted by customers. Yelp is a company whose future may be in disarray unless it dramatically overhauls its website and finds a way to monitor review postings.

The Wild Web Space: May the Force Be with You!

So how can we find a gold mine in the wild web space while it's still covered in mud? Some value investors suggest looking at a company's fundamentals. Those fundamentals are in understanding its revenue sources, its ease of use for customers and the competition factor. However, most of these valuation criteria never work for Internet growth stocks, especially in the Internet space. As we know, Internet stocks often target the public market for growth opportunities in the hopes of increasing their value. And oftentimes, the Internet companies end up costing more than they are worth because the hype of their growth makes them overvalued in the marketplace. But Internet commerce will grow at double-digit rates for years to come, and it is far from too late to start digging for winners at a reasonable price.

Disclosure: Authors have no position in the stocks listed above.

About the author:

Matthew Indyke and Brian Zen

SUPERINVESTOR.net is an investment research co-op for next-generation super investors, analysts, and advisors.

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